The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 5, December 1999, Panel Publishers, New York, NY.


By Robert W. Wood

Several reorganizations include a requirement that substantially all of the assets must be transferred or acquired. A C reorganization is an acquisition of substantially all the properties of a corporation in exchange solely for voting stock of the acquiring corporation or its parent. A D reorganization involves the acquisition by a corporation of substantially all the properties of another corporation in exchange for stock of a controlling corporation, then merged into the acquiring corporation. No stock of the acquiring corporation can be used in a D reorganization, which also must have qualified as a regular old Section 368(a)(1)(A) transaction if the merger had been into the controlling corporation.

This latter portion of the test only means that the general reorganization requirements (such as business purpose, continuity of interest and continuity of business enterprise) must also be met. It is not even relevant whether a merger into the controlling corporation could lawfully have been effected pursuant to state or federal corporate law. (On this point, see Revenue Ruling 74-297, 1974-1 C.B. 84.)

Loose Definition

Given the importance of this substantially all requirement, just what is "substantially all?" To get an advance ruling from the IRS, it is well known that assets constituting 90% of the value of the target's net assets (and 70% of the value of the target's gross assets) will qualify as substantially all. This determination is generally made on the date of the transfer. However, it is also well-settled that assets dissipated through redemptions and spin-offs that are part of the plan of reorganization are taken into account. If assets are peeled off in this way, they will obviously detract from a taxpayer's ability to satisfy the substantially all test.

The only well-known exception to this latter rule appears in Revenue Ruling 74-457, 1974-2 C.B. 122. There, the IRS concluded that cash used to pay regular quarterly dividends prior to the reorganization exchange could not be taken into account in determining whether the acquirer had ended up with substantially all of the properties of the acquired corporation.

Second Exception?

Fortunately, it appears that there is now another exception to the normally negative impact of pre-transaction distributions. The new exception comes not in a published ruling, but it is still worth noting. In Letter Ruling 199941046 a regulated investment company (a mutual fund) proposed an acquisition of another fund that it sought to qualify as a C reorganization. A few days before the transfer, a large shareholder of the target (owning in excess of 30% of its stock) surrendered its shares for redemption. This large shareholder had a legal right to do so pursuant to Section 22(e) of the Investment Company Act of 1940. Under that provision, each shareholder of an open-end management investment company has a right to put any or all of its shares to the company on any business day.

Needless to say, such a transaction could wreak havoc with the substantially all requirement. Notwithstanding the size of the redemption (involving well in excess of 10% of the target's net assets), and despite the closeness in time to the exchange, Letter Ruling 199941046 concludes that the transaction does satisfy the substantially all requirement needed for C reorganization treatment. This letter ruling makes clear that in addition to excluding the cash used to pay regular quarterly dividends, the IRS now endorses an exclusion for amounts used to meet redemptions by mutual funds (under Section 22(e) of the Investment Company Act of 1940) that are participating in a reorganization.

Such an exclusion makes eminent sense. The substantially all requirement ought to be applied with some degree of tolerance. Its principal function, after all, is to prevent transactions that are essentially divisive in character from qualifying as acquisitive reorganizations. The transaction in Letter Ruling 199941046 was certainly not divisive. The substantially all requirement should therefore not be a barrier to tax-free treatment. See Revenue Rulings 57-465 and 88-48, 1988-1 C.B. 117.

Continuity No-No

Some caution is still in order, though. This new exception is only to the "substantially all" requirement and does not extend to the continuity of interest requirement. Continuity of interest, of course, requires a substantial portion of the value of the proprietary interests in the target to be preserved in the transaction. A proprietary interest will not be considered to be preserved if, in connection with the transaction, it is acquired by the target for consideration other than stock of the target or the acquiring entity.

This ruling makes it clear that even a Section 22(e) redemption - a feature of federal law — detracts from the required percentage of continuity of interest. Continuity of interest still mandates that the assets distributed in the redemption must not exceed 50% of the value of the proprietary interests in the target on the date of the transaction.

How Much is "Substantially All?", Vol. 8, No. 5, M&A Tax Report (December 1999), p. 1.